Is Short Covering Really Propping Up the Markets?

by: Hugh Akston Investments

I ran some screens over the weekend and thought I it would be interesting to take a look at the trading behavior of our universe (market cap > $200m, daily dollar volume > $4m) as it relates to short interest. There is a theory making rounds on the Street that short covering has been propping up the market to some extent and has kept this equity sell-off from being even worse. As hedge funds unwind positions (either voluntarily or involuntarily) they are forced to cover their short positions.

Following this line of reasoning, stocks with high short interest should have performed better as artificial buying would result from funds covering their short positions. Interestingly the actual data refutes this theory. When sorting the universe by last reported short interest, you can see that stocks with higher short interest have performed worse than stocks with lower short interest. Stocks with a short interest of 40+% of the float were down on average -35% over the past four weeks while stocks with a short interest of less than 5% are down -28.5%. This phenomenon is shown across the different short interest groupings with lower short interest correlated to less price decline.

I interpret this to mean that short covering has not been propping up the market to the extent that some think. I believe this suggests there is less risk of another leg down resulting from a decrease in short covering.

Also of note is that the average stock is down -30% over the past four weeks, which historically is a dramatic move for an entire year much less a four week period.

What are the trading implications? The clear contrarian move is to increase net long equity exposure however excellent timing is required to play mean reversion as the market can remain irrational longer than an investor can remain solvent.